Implementing A Bond Strategy...VFIIX..better Than A Dividend Champion In Risk Vs Reward ?

Jan. 24, 2012 6:29 PM ET

Implementing The Strategy of Increasing Bond Yields By Watching the Spreads….and Finding Possible Challengers to a Dividend Champion Stock at The Same Time

VFIIX..better than a Dividend Champion in Risk vs Reward ?

Previous articles have given the rationale and methodology of structuring a bond portfolio. Those bond holdings in my view offer a more stable strategy for a core holding in a retirement portfolio than dividend stocks.

Before going into spread strategies and ETFs, I would like to mention a bond fund which has been a core holding of my client portfolios for at least 10 years. This is the Vanguard GNMA mutual fund (MUTF:VFIIX). The fund is one of those quirks of the bond market and offers pretty close to a free lunch: higher returns than Treasuries but minimal risk. The securities the fund invests in are mortgage securities. But unlike those of FNMA or other originators, they carry the full faith and credit of the US government. In other words the credit risk is the same as US treasuries.

Of course for those that wouldn't touch the credit risk of the US government this is not an appropriate investment. For the rest of us this is the ability to pick up about 1.5% over treasuries with minimal risk from fluctuations in principal value is quite attractive. Because of the relatively short duration of the portfolio the yield on the fund will adjust as inflation and interest rates rise, but price will remain fairly steady.

Below is a price chart of VFIIX. There was not a single year of negative returns --see the Morningstar analysis at the bottom of the page. not a single year of negative returns. The price chart shows a steady climb with no major volatility (note how small the scales is). Nice and boring, significant yield over treasuries, steady growth…just the perfect allocation for a core bond holding.

One aspect of bond fund or ETF investing that advocates of Dividend Growth and/or DRIP investing, is that a similar strategy can be employed with a bond fund or ETF. And some of the results are quite similar: a compounding growth of the account value and a modest increase in a measure used by thse investors:"yield on cost". But the advantage in the bond fund is that the dividend flow, which is based on interest rates will adjust with inflation, while a decline in interest rates gives a bit of growth in the net asset value of the fund, producing an attractive low risk total return.

This fund meets exactly the crieria of a core portfolio holding in the bond allocation of a portfolio….as it has been in my client portfolios for many years. In fact it is often used as a place to put money that would be needed in the near term but not immediate future. Examples of that would be a child approaching college years, or the next 3 -5 years expenses for a retiree.

Looking at total return(see the analysis in the tables and graphs at the bottom below the line) one gets this interesting result: $10,000 invested in VFIIX in 2002 with dividends reinvested grows to a bit over $12,500 in 10 years. The same amount invested in dividend champ KO would be worth around $7500,an investment in T would produce virtually identical return and $10,000 in PG would have produced an impressive return close to $17,500. Looking at the fluctuations in the stocks vs, the steady climb in the value of the VFIIX investment it's clear the bond investment is far less volatile yet produces higher total return than KO a major dividend champt . IfI understand correctly the YOC calculation would go as follows: for VFIIX the $10,000 initial investment with the current yield of 3.17% on $12,500 dividend would produce $396 in dividends which if I understand correctly is a yield on cost of 3.96%.

I look at the investment a bit differently, if I collect the 2012 dividend and the price stays the same I could liquidate my position and walk away with 12,896 a total return of 28.96%. Call me crazy but that to me is the proper way to evaluate the investment : the amount I could cash out with. Out of dividend champions, T returned about the same as VFIIX, KO significantly less , and PG considerably more. All of course with less volatility. A total return analysis from Morningstar is below the line.

Is VFIIX a competitor to dividend champion KO ? I'll leave that to others to make the conclusion. For myself and my clients it makes a very useful stable competitor in terms of risk and return.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.